Profitability in the Field of Consulting and Professional Services: A Simple Financial Model

Disclaimer

It is important to understand that any financial model is a compromise between the accuracy and simplicity of its calculations. The financial model described in this article, and how it was developed, should not be considered completely accurate. All information is of an estimated and simplified nature.

Introduction

We are going to use the example of a small software development company called SmartSoft, and create a simplified financial model to determine the main parameters that affect the profitability of this business.

Kindly note that SmartSoft is a fictional company. All characters and events mentioned in this article are purely fictional.

It is also worth noting that only 10 employees are directly involved in the projects at SmartSoft. These are project managers, developers, analysts, and testers. The company also has an accountant, a lawyer, an office manager, and a chief executive officer.

Furthermore, the company rents an office in an A-grade business center and has a specific budget allocated for advertising and marketing.

The purpose of this example model is to determine how much SmartSoft must earn on its projects to ensure a given level of operational margin.

By clicking on this link you can download our Excel spreadsheet, add your required parameters into the spreadsheet, and receive key indicators for your organization.

Key Features of the Business in the Field of Professional Services

First of all, it is important to understand that in the majority of consulting companies, and in the field of Professional Services in general, the project approach is the most common way of working with clients. Here are several examples of projects in the Professional Services field: conducting an audit and preparing IFRS statements, designing a new building, launching a new product on the market, and developing an information system. It is, therefore, fair to say that projects in the field of professional services are aimed at creating an intellectual product or service.

The second feature of the Professional Services field is that projects are implemented at the expense of time, knowledge, competencies, and employee experience. Consider the following: a project that aims to develop and implement management reporting does not require the purchase of materials, organization of logistics, or rental of warehouse premises, but requires the time and intellectual efforts of auditors, analysts, financial consultants, and other team members.

Employee time is therefore the main production resource in the Professional Services field. This resource is limited because employees cannot work more than 24 hours a day, even if they want to. In addition, this resource is not free. Do not forget that employees receive a salary for their time.

If we think abstractly for a moment, the owner of a consulting company understands their business in the following way: the company «buys» time from its employees, and then sells it to clients as part of projects. The proceeds from the sales should cover the expenses of this «purchasing» of time, as well as overhead and administrative expenses, and leave at least a small profit for the owner.

The profitability of a business in the Professional Services field depends on the profitability of each individual project.

Profitability

The profitability of a business is determined by this simple formula:

Profitability = Profit / Revenue

Thus, the profit is the revenue after deducting all expenses:

Profitability = (Revenue - Expenses)  / Revenue

Within the framework of this model, we will assume that the company receives revenue only from the implementation of projects.

Expenses can be divided into two categories: direct and indirect.

Direct expenses are those that can be directly attributed to any project. For example, if contractors are involved in the project, then the payment for their services will be added to direct expenses.

In the Professional Services field, the primary direct expense is generally the cost of labor or the «purchase» of employees’ time. Since this cost is the primary direct expense, we will allocate it separately, and we will allocate all other direct expenses to the «Other direct expenses» category:

Direct expenses = Cost of labor + Other direct expenses

Indirect expenses are those that cannot be explicitly attributed to any project. For example, office rent or payment for the work of back-office departments (accounting, legal services, etc.). Indirect expenses are divided into Administrative and Overhead expenses.

Indirect expenses = Administrative expenses + Overhead expenses

Depending on what expenses are considered in the calculation, gross margin and operating profitability are also allocated:

Gross margin = Gross Profit / Revenue  
= (Revenue - Direct expenses) / Revenue  
= (Revenue - Cost of labor - Other direct expenses) / Revenue

Operating margin = Profit / Revenue  
= (Gross profit - Indirect expenses) / Revenue  
= (Revenue - Cost of labor - Other direct expenses - Overhead expenses 
    - Administrative expenses) / Revenue

Thus, gross margin shows the effectiveness of project implementation, and operating margin shows the efficiency of the entire business.

Utilization

Utilization (also «application» or «useful usage») is a key indicator of using employees’ time efficiently in the Professional Services field. It demonstrates the proportion of employees’ time spent on billable projects.

In other words, utilization shows what proportion of the time the company managed to sell to a client or the client «purchased» from an employee.

It is impossible to utilize all employee time on commercial projects. For example, time spent on employees’ annual leave, training and mentoring, presales, internal projects, and organizational activities. Such activities are not paid for by clients, which means they reduce the level of utilization.

The prime cost of non-utilized time is a part of the overhead expenses of the company. The company is therefore objectively interested in ensuring that the utilization of employees reaches its maximum level.

On the other hand, employees should still have the time to develop and organize their own work. Constant work with a utilization level close to 100% leads to rapid burnout.

To determine the target values of utilization, it is recommended to allocate qualification categories (or «grades») and set a target value for each grade:

Let us assume that all SmartSoft employees involved in projects work according to a standard schedule of 40 hours a week (i.e., 5 working days of 8 hours, and 2 days off). Each month has a different number of working days and, accordingly, working hours; however, on average, each working month with a 40-hour working week contains 164 working hours.

We will plan the utilization of SmartSoft employees and calculate the average number of utilized and non-utilized hours per month for each specialist:

Prime Cost

The prime cost of the project is determined by the number of labor resources invested in the project. If an employee participates in several projects at the same time, the amount of time spent on each of the projects must be determined. This share of time can be expertly estimated, but more accurate results can be obtained by using an established process of time allocation.

Working time is generally allocated in hours. At the end of the month, the company gets an idea of how many hours employees spent on certain projects.

To calculate the prime cost of a project, the number of hours spent by an employee on a project must be multiplied by the prime cost rate of an employee’s hour of work.

The prime cost rate shows the price of one hour of work by an employee for the company. This is the rate at which the company «buys» each hour of an employee’s time.

In our model, we will include only direct expenses per employee in the calculation of the prime cost of one hour (payroll and related deductions, additional payments). We will calculate the average management rate.

For example, the Project Manager of the 5th grade in SmartSoft has a monthly salary of 3,199 euros, including all deductions. Once a year, they receive a bonus of 6,402 euros (including all deductions). As a result:

The total amount of expenses per employee per month = 3,199 + 5,038 / 12 = 3,732 €

The prime cost rate = 3,732 / 164 = 23 € per hour.

We will calculate the prime cost rates for all SmartSoft employees:

The full amount of monthly expenses will include the salary and the average monthly bonus of employees (considering personal income tax and all deductions related to these payments).

Target Operating Margin

The target operating margin is a model parameter that will be used as the basic value for all further calculations. The target operating margin is usually determined by the owners or top managers. By determining the target operating margin, we record what return is expected from the funds spent on doing business.

Let the target operating margin of SmartSoft be 15%.

We are going to keep this value in mind because we will use it soon.

Target operating margin of 15%

Administrative Expenses

Administrative expenses may vary from month to month. For example, SmartSoft could pay office rent once a quarter and not every month. For calculations within the model, we will estimate the average monthly amount of administrative expenses:

We will add the payroll of the back-office employees to the administrative expenses. For example, the salary of the CEO, including all taxes and deductions, is 4,570 euros per month. Additionally, once a year, the CEO receives a bonus of 9,144 euros. In this case, the average monthly expense for the CEO is the following:

4,570 + 9,144/12 = 5,332 €

The total amount of administrative expenses of SmartSoft will be equal to 19,633 €

We are going to keep this value in mind because we will use it soon.

Administrative expenses of 19,633 € / month

Overhead Expenses

Let us estimate the average amount of overhead expenses per month.

To simplify the model, we will assume that overhead expenses are determined only by non-utilized hours.

Let us take the example of a trainee analyst from SmartSoft. Earlier, we determined their target utilization at the level of 40%. So, on average, they have 98 non-utilized hours per month. This could be time spent on training, internal tasks, internal projects, and similar activities.

The prime cost of these unused hours will be attributed to overhead expenses. The calculation is quite simple: the number of non-utilized hours is multiplied by the previously determined prime cost rate of this employee:

98 * 6 = 588 € per month.

We will perform a similar calculation for all employees:

Thus, the total prime cost of non-utilized hours per month is 6,876 €. This amount will be attributed to the overhead monthly expenses.

We are going to keep this value in mind because we will use it soon.

Overhead expenses of 6,876 €/month.

The Prime Cost of Labor for Projects

Previously, we defined a target utilization value for each employee. Remember, utilized hours are the hours spent by employees on billable projects. Keeping in mind that we know the target amount of hours spent by employees on billable projects every month, and we know the prime cost rates of employees, we can calculate the average monthly direct expenses for projects under the «Prime cost of labor» item of expense:

By summing up these values, we can calculate the total target monthly cost of all projects at the given level of employee utilization: 14,280 euros/month.

We are going to keep this value in mind because we will use it soon.

The prime cost of labor of 14,280 €/month.

Other Direct Expenses

To simplify the model, we will assume that there are no direct expenses in SmartSoft projects, except for the prime cost of labor.

This simplification is acceptable since it is common to cover all other direct expenses by the client.

For example, if the project involves a business trip, the expenses of organizing the trip are included in the project budget in a separate line and are paid by the client. Thus, direct expenses are compensated, and they can be ignored in the calculations.

Target Revenue

Let us return to the formula for calculating operating margin:

Operating Margin = 
(Revenue - Prime cost of labor - Overhead expenses - Administrative expenses)  / Revenue

We can adjust it a bit and get a formula for calculating revenue:

Revenue = (Cost of labor + Overhead expenses + Administrative expenses) / (1 - Operating margin)

In the previous sections, we defined all the variables we need to calculate the target revenue of SmartSoft:

• Target operating margin: 15%
• Administrative expenses: 19,633 €/month.
• Overhead expenses: 6,876 €/month.
• Prime cost of labor: 14,280 €/month.

Let us add all these values into the formula and determine the amount of revenue SmartSoft should receive on average per month to ensure the target operating margin:

Revenue = 40,789 / (1 - 0,15) = 47,987 €/month.

We are going to keep this value in mind because we will use it soon.

Target revenue of 47,987 €/month

Target Gross Margin

Let us recall the formula for calculating the gross margin of projects:

Gross margin = Gross Profit / Revenue
 = (Revenue - Direct expenses) / Revenue
 = (Revenue - The prime cost of labor) / Revenue

In the previous sections, we defined all the variables we need to calculate the target gross margin for SmartSoft projects:

• Revenue: 47,987 €/month.
• Prime cost of labor: 14,280 €/month.

Let us add all these values into the formula and determine the target gross margin of SmartSoft projects:

Gross margin = (47,987 - 14,280) / 47,987 = 0,70

Thus, in the case of SmartSoft, to ensure an operating margin of 15%, each individual project must be carried out with a gross margin of 70%.

We are going to keep this value in mind because we will use it soon.

Target gross margin of 70%

Billing Rates

The billing rate is the cost of an employee’s hour of work for clients. The most common way to estimate the cost of a project for a client is to estimate the planned labor expenses for the project in the context of roles and grades, and then multiply these planned labor expenses by the billing rates for each role and grade.

The billing rate includes:

• The rate of gross margin.
• The prime cost.

Let us consider the procedure for calculating the billing rate with an example of a Tester of the 1st grade (or «trainee»). Earlier, we determined that the prime cost rate of such a specialist is 5€/hour.

For SmartSoft to reach its target gross margin of 70%, the rate of profitability should be put into the billing rate of each hour. Therefore, if we make the calculations for one hour, we get the following formula:

0.70 = (Billing Rate - 5) / Billing Rate

A simple conversion gives us a formula for calculating the Billing Rate for a Junior Tester:

Billing Rate = 5 / (1-0,70) = 17 €/hour

After performing similar calculations, we get billing rates for all SmartSoft employees:

Conclusion

Billing rates calculated by using roles and grades allow you to compare SmartSoft with competitors. If it turns out that competitors have significantly lower rates, SmartSoft should have significant advantages so that all the clients will definitely choose them. For example, rates above the market can be kept if the company has unique expertise.

But what if the billing rates are still too high? Answers can be found in each section of the considered model.

1. Target operating margin. The simplest and the most obvious step is to lower your expectations, for example, to reduce the target operating margin from 15 to 10 percent.
2. Administrative expenses. Optimization of administrative expenses is also a fairly obvious step. For example, you can move from an A-grade office to a cheaper business center or reduce the cost of accounting and legal support for the business by outsourcing some or all functions.
3. Overhead expenses and prime cost price. Overhead expenses and labor expenses are combined into one item since their optimization is closely related to the revision of the team structure. If a company performs typical and standard projects, it makes no sense to hire many high-grade specialists. The ratio between expensive high-grade specialists, interns, and middle-level employees should be determined based on the complexity and innovation of the projects implemented in the company. This aspect is perfectly described in the " Managing The Professional Service Firm» book by David Maister. In addition, to optimize overhead expenses, you need to plan for and control utilization.

In summary, the main factors affecting the financial model are (in descending order of the degree of influence):

1. Team structure and planned utilization.
2. The rates of the prime cost of labor of employees.
3. Target operating margin.
4. The total amount of administrative expenses.

Our cloud service Timetta was created specifically for the Professional Services field. Timetta allows you to plan and track working hours, quickly monitor the utilization of each employee, control prime cost, and plan and track gross financial indicators and gross margins for your projects.